S&P Downgrades See Muted Market Response

Less than a week after the New York-based company cut its
ratings of nine countries including France, the French 10-year
bond is little changed at 3.08 percent and borrowing costs fell
this week at the country’s sale of 8.59 billion euros ($11
billion) in bills. Spain, whose rating was lowered by two levels
to A, sold debt at half the interest rate of a month ago.

The response was the same last August, when financial
markets dismissed the U.S.’s loss of AAA status by pushing the
yield on the 10-year Treasury note to a record low of 1.6714
percent just seven weeks later. S&P may be further behind the
curve as investor sentiment improves after the European Central
Bank twice reduced interest rates and offered banks unlimited
cash to support the banking system.

“By the time the ratings agencies get around to doing
their paperwork, everyone knows it’s going to happen, so the
market moves faster and prices everything,” said Carl Weinberg,
chief economist and founder of High Frequency Economics Ltd. in
Valhalla, New York. “We’ve seen no bump in Europe since last
week, or last year in the U.S.”

Just over a month since S&P imposed ratings warnings on 15
euro nations, the company said Jan. 13 that it was downgrading
nine countries after concluding recent policy steps may prove
“insufficient” to contain a fiscal crisis now in its third
year. Germany was left as the euro-area’s only stable AAA.

Muted Reaction

The fallout in financial markets has been muted. Spain
yesterday paid an average 2.049 percent to sell 12-month debt,
compared with 4.05 percent on Dec. 13. The previous day, France
auctioned 1.895 billion euros of one-year notes at a yield of
0.406 percent, down from 0.454 percent on Jan. 9.

Like the U.S., France was downgraded one step to AA+ from
AAA. Since September, French bonds have lost 1.56 percent,
compared with a 1.73 percent gain for Germany, Bank of America
Merrill Lynch indexes show. It costs more to insure the debt of
France than South Africa and the Philippines, according to data
from CMA, and the euro is down 4.8 percent versus the dollar.

Investors anticipated S&P’s action, said David Shairp, a
global strategist at JPMorgan Asset Management in London.
“While it is a blow to national pride, the implications of
these downgrades may be limited since these moves were carefully
signaled in advance. Indeed, a downgrade to the French rating
was already reflected in the spreads.”

‘Worse’ Than Reality

The moves were “a case of your fears being worse than the
reality,” said Steven Bell, a former U.K. Treasury official who
is now chief economist at hedge fund GLC Ltd. in London. “The
reality is that the European situation is improving massively,”
with the ECB lending facility being “a massive game changer,”
he said.

In downgrading France and the other nations, S&P cited the
inability of government leaders to find a solution to reducing
the region’s debt, saying “the political agreement does not
supply sufficient additional resources or operational
flexibility to bolster European rescue operations, or extend
enough support for those euro-zone sovereigns subjected to
heightened market pressures.”

“Politics are relevant with a small p,” Bell said. “One
of the key points S&P have made is that you need a functioning
political process to solve these problems.”

Congress’s Failure

S&P, a unit of McGraw-Hill Cos. (MHP), blamed “uncertainty” in
U.S. policy making Aug. 5 when it cut the assessment of the
government’s ability to pay its debt, citing Congress’s failure
to agree on as much long-term deficit reduction as the credit-
rating company wanted. Warren Buffett, the world’s most
successful investor, said S&P erred and the U.S. should be rated
“quadruple-A.”

Investors often look to sources other than ratings
companies for insights on the value of bonds, said Robin Marshall, director of fixed income at Smith & Williamson
Investment Management in London. “Most investors do their own
due diligence rather than relying on rating agencies alone. Look
at the U.S. Treasury yields that have not stopped falling since
it lost its top rating.”

For now, S&P is standing alone, as Moody’s Investors
Service and Fitch Ratings haven’t changed their grades. David Riley, head of the sovereign-debt unit at Fitch, said Jan. 10
that France probably will retain its credit rating this year
unless Europe’s fiscal crisis worsens.

ECB Action

Investors also may be taking their cue from more positive
events, such as the ECB’s December loan to 523 banks of 489
billion euros for three years, said Joost van Leenders, a
strategist at BNP Paribas Investment Partners in Amsterdam, who
helps oversee about $780 billion.

Under terms of that operation, banks can borrow the money
from the ECB at 1 percent and use it to buy bonds at debt
auctions. Signs that the euro-region’s economy may have stopped
deteriorating also may be helping to drive bond sales, with the
ZEW Center for European Economic Research yesterday reporting
German investor confidence jumped the most on record in January.

“The expansion of the ECB support here is really the
critical issue,” said Jeffrey Rosenberg, chief investment
strategist for fixed income at New York-based BlackRock Inc.,
the world’s biggest money manager. “The ECB with its funding
support is reducing the risk of bank failure. Systemic risk
overall is reduced in an environment of greater ECB support. The
impact of a downgrade isn’t as dire as it might otherwise be.”

Calming the Debate

S&P might have erred in downgrading Europe’s bailout fund,
said Lutz Karpowitz, senior currency strategist at Commerzbank
AG in Frankfurt. The European Financial Stability Facility has
liabilities of only 21 billion euros, so it still can issue
“quite a few bonds without exceeding its AAA guarantee
volume,” he said. “This more-than-remarkable approach on the
part of S&P is not going to contribute to the debate surrounding
the rating agencies calming down.”

John Piecuch, an S&P spokesman, declined to comment.

While German Chancellor Angela Merkel said the S&P
announcement validated her push for tougher budget discipline,
other policy makers either are playing it down or suggesting it
be ignored. French President Nicolas Sarkozy called the French
shift a nonevent that “changes nothing.”

German Foreign Minister Guido Westerwelle said yesterday
it’s “high time” to create a European company to compete with
established U.S. raters.

‘Pay Less Attention’

ECB President Mario Draghi questioned the importance of the
companies on Jan. 16 and suggested “we should learn to do
without ratings, or at least we should learn to assess
creditworthiness.” Bank of England Governor Mervyn King said
yesterday that “markets have gone some way towards that where
they pay less attention to the rating agencies.”

The concern has been “primarily in terms of their
competence and in terms of their pro-cyclicality,” King said.
“They got carried away themselves by the hubris surrounding the
financial sector before the crisis, and once the crisis has hit,
they rush in to be the first to downgrade and then create a pro-
cyclical process.”

Investors showed no reluctance to lend to the U.S. after
S&P stripped the country of its AAA rating. While the Aug. 5
downgrade set off a 6.7 percent decline in the S&P 500 stock
index the next trading day, the yield on 10-year Treasuries was
still just 1.86 percent yesterday. Investors bid a record $3.04
for each dollar of the $2.14 trillion of Treasury notes and
bonds sold last year, according to data compiled by Bloomberg.

Rising Yields

Ten-year yields for the nine nations that lost their AAA
status between 1998 and the U.S. downgrade rose an average of
two basis points the next week, according to JPMorgan Chase & Co.
research.

History suggests that a rally following a downgrade isn’t
unusual. After S&P cut Japan in February 2001 to AA+ from AAA,
10-year bond yields fell below 1.15 percent four months later
from 1.46 percent. Yields were at 0.961 percent on Jan. 17, even
though S&P ultimately reduced the nation to AA-. Moody’s waited
until May 2009 to lower Japan’s foreign-currency rating from Aaa,
and now has it at Aa3, the same as S&P.

None of the 17 euro countries can print its own money,
unlike the U.S., making it easier for the world’s largest
economy to pay its debts. Fighting the credit crisis also
sometimes requires the support of all 27 European Union members,
slowing decision-making and leading to ideological rifts.

French Debt

While some funds are required to hold debt with certain
ratings, few will be forced to sell French debt as a result of
the downgrade, Nikolaos Panigirtzoglou, a JPMorgan analyst in
London, wrote in a Dec. 9 report. About 160 billion euros of the
country’s 940 billion euros in bonds are held by non-European
banks, insurance companies and pension funds that may opt to
scale back their investments, he wrote.

The rating cuts still could trigger some forced selling by
investors who are required to hold only the highest-quality
securities in their portfolios, said Pacific Investment
Management Co.’s Bill Gross.

“There are regulatory issues in the case of structures
that are dependent on certain types of ratings; and to the
extent that various countries get downgraded, then those
positions have to be reduced, if only because of regulation,”
Gross, manager of the world’s biggest bond fund, said in a Jan.
17 radio interview on “Bloomberg Surveillance” with Tom Keene
and Ken Prewitt.

Nations have proved adept at skirting these rules, said
Noel Hebert, a credit strategist at Mitsubishi UFJ Securities
USA Inc. in New York. U.S. funds largely avoided selling
Treasuries, and the ECB is likely to keep its rules flexible.

“Between the government basically calling the agencies
idiots, changing accounting treatments as need be and arguing
that everything is baked in, in sovereigns at least their role
looks to be getting increasingly marginalized,” he said. “Life
is easier if you just close your eyes and pretend the bad stuff
isn’t happening.”